Friday, October 23, 2009

The idiocy of subsidies

Suppose one day the government decided to give $1 to every person who buys a screwdriver. What would happen?

The immediate effect would be to increase the price of all screwdrivers by $1. Why? If the going rate for screwdrivers is (say) $5, then that is what someone who actually needs a screwdriver is willing to pay. (Put another way, that is the “economic utility” of a screwdriver. Put yet another way, that is the “market clearing” price that balances screwdriver supply with screwdriver demand.) If you pay $6 for a screwdriver and get a $1 rebate, from your point of view that is identical to simply buying the screwdriver for $5; either way, you are parting with $5 and getting a screwdriver, which you do because $5 is the screwdriver’s economic value to you.

Any idiot can see that this hypothetical government policy is not a gift to screwdriver buyers; it is a gift to screwdriver sellers. That gift would be shared with buyers only to the extent that it encouraged the production of screwdrivers in excess of natural demand.

Which brings us to the first-time home buyer tax credit, where the government reimburses buyers 10% of the price of the house or $8000, whichever is smaller. By the screwdriver analogy, this should have the simple effect of increasing the price of every starter home by $8000, right?

Wrong. Nobody buys a starter home with cash. The tax credit does not add $8000 to someone’s capacity to buy a house; it adds $8000 to their capacity to make a down payment. Maybe they take out a loan with 20% down. Or maybe they get an FHA loan with 10%, 5% or even 3.5% down. So the tax credit increases their purchasing power by $40k (20% down) or $80k (10% down) or $160k (5% down) or more.

Thus the net effect is twofold:

Increase the price of all starter homes by $100k or more

Increase the supply of houses

Is the problem with the housing market too little supply? Because that is the only “problem” this tax credit is solving.

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Bottom line: While the tax credit is in place, it is a good time to sell a house and a great time to be a bank. It is a bad time to buy a house and a terrible time to be a U.S. citizen.